How to Buy a Zero State Tax Liability

If your state income tax liability is too high, there’s an easy way to lower it: buy state tax credits from someone who doesn’t need them. It may sound outrageous, since after all, it’s illegal to sell off unneeded expense account receipts to someone who could use the tax deduction. But it’s perfectly legal. In fact, for states who wish to encourage industry, it’s a condoned and common practice.

There are three kinds of state tax credits: 1) transferable 2) refundable and 3) nontransferable and nonrefundable. The federal government does not allow the transfer of federal tax credits.

Almost every state that levies an income tax creates incentives for small business in the form of tax credits. According to Danny Bigel, CEO and co-founder of TheOIX.com, who facilitates the market for these credits, states issue about $10 billion in state tax credits annually with half of those being transferable. In California we have, among others, such credits as the Research and Development credit, the Empowerment Zone credit and the Enterprise Zone credit. These credits attract businesses that have large research and development departments and also bring industry and housing into areas suffering from urban decay.

Oftentimes, the holder of the credit doesn’t rack up enough of a state tax liability in order to use it, but they may have the option to carry forward the credit to subsequent years when it will prove beneficial. But for holders who need working capital right away, some states have made many of these credits transferable, and can put the credit on the open market.

You may wonder why states have made this type of transaction legal. Think of the boon this is to a business’ supply of working capital. First of all, a business is usually in a bad financial position if it cannot use a tax credit. This usually means the business had such a bad year that it had no liability whatsoever. If a business can sell an unused tax credit, it will improve its cash flow.

Traded credits go for as low as $20,000 all the way up to $20 million, according toBigel. “The OIX is bringing a traditional bid/ask market dynamic to the transferable tax-credit space on a state-by-state basis. With the OIX, businesses and individuals (typically high net worth) can get in the game to offset their state tax liability,” said Bigel.

He added that selling credits is a win for all parties. “[Businesses] reduce their liabilities and pick up immediate yield; they’re providing liquidity and they now have more income to invest in their community. Sellers and buyers and therefore the states win.”

The ability to transfer tax credits is a relatively new phenomenon, but has been taking place in California for a little more than a decade. It’s brought up questions, such as what would happen if a taxpayer’s transfers a credit and the credit is partially or completely disallowed in a subsequent audit. The kinks will get worked out as time passes. And maybe this is just what the IRS is waiting for – a smoothed out protocol before they decide to instigate the same transactions at the federal level. Perhaps this is considered a key to resolving some of our economic issues.